What did we learn this week? (04/28/2023)-Sometimes History Doesn't Even Rhyme
It was reported recently that 60% of Wall Street economists are looking for a recession to begin in 2023. Count that as one of many historical oddities of the current economic cycle. In the past, recessions were rarely ever so widely predicted. I have written, as have many others, about the surprising resilience that the US economy has displayed. Leading Economic Indicators (LEI) (illustrated below) are clearly pushing deeper into recession territory. But every cycle is unique, and this cycle is being supported by a few unprecedented factors.
While consumer demand remains slow, it isn’t terrible. Over the last six months real consumer spending has been growing at roughly 1.5% to 2%. While we are starting to see some significant cracks in the labor markets, there has not yet been enough weakness to break the upward pressure on wages. Today’s Employment Cost Index (ECI) ticked higher sequentially and is running at a 4.7% annual rate. In other words, after the fastest and longest Fed tightening in four decades, policy has not yet proven restrictive enough to get labor inflation down. One not surprising outcome of higher wages and higher real income growth is resilient consumer demand. There is little evidence that consumer demand for non-housing services is going to weaken anytime soon, and therefore neither should employment and wage growth in the services sector.
Where one would have expected to be seeing more economic weakness is housing. Not many economists would have guessed or even imagined that we could possibly be in an environment with mortgage rates bouncing between 6.5% to 7%, affordability at historical worsts, and yet we still have significant parts of the country where bidding wars are common, and pricing is making new highs.
The lack of existing home inventory (as opposed to newly built) is unique to this cycle. The Fed and unfortunately some now insolvent banks, bought a ton of mortgage-backed securities in 2020 and 2021 pushing mortgages rates to historic lows leading to a situation where two years later most homeowners are locked into 30-year mortgages at a rate of below 4% and many below 3%. The outcome is that homeowners are loath to leave their houses. Currently more than a third of homes available for sale are new homes vs a normal environment where new homes comprise about 10% of listings. Homebuilders reporting Q1 earnings have consistently reported that demand trends have held up through April. Can this last? I have no idea, given we don’t have any precedent.
What I will say is that while there is a mountain of evidence suggesting a recession is imminent but forecasters need to have the humility to admit that there are dynamics in this cycle that are different from previous cycles. The GFC was all about a collapse in housing prices. Given that housing prices shot up almost 40% nationally from the start of the pandemic, it was reasonable to assume that the reversal of excess stimulus would also reverse much of that asset inflation. But it hasn’t happened and given that the constrained structural supply dynamic isn’t going away, maybe it’s possible that housing hangs around at these high price/bad affordability levels for a long time.
The last dynamic that I think is unique to this cycle is the high level of accumulated wealth and the potential acceleration to the velocity of that money in the economy because of the baby boomers bequeathing some of that wealth to the next generation. Much has been made of the move lower in M2. The below chart shows just how rapid the drop in the money supply has been, but it also shows the massive ramp in deposits since the pandemic. In other words, falling M2 on a y/y basis shows that savings are falling and that should correlate with slower consumer spending, but there has been a huge growth of deposits above trend that will take time to normalize.
It appears to me that normalization will take longer than the LEI, inverted yield curves, tightening credit and precedent would suggest. Real income growth remains strong due to a structurally tight labor market. Home prices aren’t falling because there is a structural supply restriction of existing home supply. Unprecedented, accumulated wealth is driving more consumption because of a structural demographic reality.
None of that is to say there won’t be a recession. The factors enumerated above also means that the Fed has more work to do and that they are likely to stay at higher rates for a longer period of time than either the equity or the bond market is pricing in.
Tim Pierotti is WealthVest’s Chief Investment Officer.
Tim has over 25 years of experience in various aspects of the equities business. Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management. Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund. Tim is a graduate of Boston College and lives in Summit NJ.
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